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Tim Duy

Alarm Over the Fed's $4.45 Trillion Balance Sheet Is Silly

The central bank still has a long way to go before it's time to trim its bond holdings.
Holding her fire.

Holding her fire.

Photographer: Aaron P. Bernstein/Getty Images

The Federal Reserve is laying the groundwork for shrinking its $4.45 trillion balance sheet. But don’t panic yet, bond traders. This isn’t 2013.

A parade of speakers --- Fed Chair Janet Yellen, Governor Lael Brainard, and San Francisco Fed President John Williams -- is clearly priming the market for a future statement that says “the FOMC decided to reduce the reinvestment of principal payments” from its balance sheet holdings. Why now? Does 50 basis points of interest-rate increases mean the central bank is “well under way” toward rate normalization and can now justify holding the proceeds from bonds that mature rather than funneling the cash back into the economy by way of further bond purchases?

By itself, 50 basis points doesn’t push very deep into normal territory. But the Fed is looking forward to another 75 basis points of tightening this year, for a total of 125 basis points, or 1.25 percentage points. Still not much of an increase -- except that the definition of “normal” changed dramatically over the past year. The median estimate of the neutral federal funds rate has fallen in recent months from 3.8 percent in June 2015 to 3.1 percent now. It was 4.25 percent back in January 2012.

The drop in the expected terminal point for policy changes the definition of normal, which then changes the timing of balance sheet normalization.

Yellen estimates that the impact on financial conditions of ending reinvestment of principle payments during 2017 would be a 15 basis-point increase in 10-year Treasury yields, equivalent to two 25 basis-point increased in the target fed funds rate. But those who remember the infamous “Taper Tantrum” of 2013 may disagree and fear a much larger response from bond traders. Recall that yields jumped 100 basis points in the months after then Fed Chairman Ben Bernanke’s hinted at ending quantitative easing. I wouldn't expect a repeat.